Enhanced Indexing

DEFINITION of 'Enhanced Indexing'

Enhanced indexing is an investment approach that attempts to amplify the returns of an underlying portfolio or index. Enhanced indexing also attempts to minimize tracking error. This type of investing is considered a hybrid between active and passive management and is used to describe any strategy that is used in conjunction with index funds for the purpose of outperforming a specific benchmark.

Enhanced indexing also resembles active management because it allows managers the latitude to make certain deviations from underlying index. These deviations can be used to boost returns, minimize transaction costs and turnover, or to maximize tax efficiency.

Finance experts are split on whether enhanced indexing is truly active or passive.

How Enhanced Indexing Works

Investors can short-sell poor performing stocks from an index and then use the funds to purchase shares of companies they expect will have high returns, in effect tilting the index fund’s weights. Investors could outperform a benchmark over long time horizons by consistently eliminating their exposure to poor performing stocks and by using the proceeds to invest in other securities.

Enhanced index funds can be more profitable than regular index funds by:

Positioning the portfolio to a particular sector

Timing the market

Investing only in specific securities in the index

Avoiding certain securities in the index that are expected to underperform

Using leverage

Keeping up to date with market trends

Drawbacks of Enhanced Index Funds

Since enhanced index funds are essentially actively managed, the investment has additional risk in the form of management risk, whereas index funds only have to worry about market risk. Poor choices by the manager can hurt future returns. Also, because enhanced index funds are actively managed, they have higher management expense ratios compared with index mutual funds.

Enhanced index funds typically have expense ratios between 0.5% and 1%, compared with 1.3% to 1.5% for regular mutual funds. Because enhanced index funds are actively managed, they typically involve higher turnover rates, which means more brokerage transaction fees and capital gains. They are also newer investment instruments and do not have that long of a track record to compare performance.